Real Options in Theory and Practice

Graeme Guthrie

Financial Management Association Survey and Synthesis

Real options that arise in the real world often vary radically from one problem to another. These differences may arise due to the particular real options embedded in the projects and the order in which they can be exercised. They may arise due to different underlying sources of uncertainty (with possibilities ranging from easily observable commodity prices to almost unquantifiable factors such as the technological viability of a project. The possibilities are almost endless. This book focuses on building a general approach to solving real options problems from the ground up to show readers how real options can be assembled in a way appropriate to the individual problem being analyzed. The book, part of the Financial Management Association Survey and Synthesis Series, contains a CD with spreadsheets that can be used to fit the wide variety of real-world problems that readers will confront.

Real Options in Theory and Practice

Graeme Guthrie

Financial Management Association Survey and Synthesis

Description

Decision-makers in business and economics face a staggering array of problems. For example, managers of growing firms have to decide when to expand their business, governments have to decide whether to undertake large infrastructure investments, and managers of oil firms must decide how rapidly to deplete their reserves. While these problems seem quite diverse, they all share many important features. In each case, the decision-maker must choose when to take a particular action that will be potentially impossible to reverse, and the consequences of taking (or not taking) that action are uncertain. Also, the timing and nature of these actions directly affect the cash flows generated by the entities they manage. This book explains how techniques originally developed to price financial derivatives can be used to analyze real-world decisions, and provides the tools necessary to put them into practice.

The real options analysis approach to decision-making is built on strong theoretical foundations, and is widely discussed in practitioner literature, but often only at a fairly intuitive level. What practitioners need-and what this book delivers-is a structured approach to systematically applying real options analysis to the wide variety of problems they will meet in business and economics.

Real Options in Theory and Practice focuses on building up a general approach to solving real options problems from the ground up. Rather than aiming to build a "black box" to solve a small set of standardized real options problems, it describes the building blocks of any successful real options analysis and shows how they can be assembled in a way that is appropriate to the problem being analyzed. And for all of the numerical examples in the book, there is an accompanying CD that contains spreadsheets ready to use on the wide variety of applications the book brings into the picture. For both practitioners and academics, Real Options in Theory and Practice will serve as an authoritative and invaluable resource for those looking for effective and practical solutions to complex, real-life problems.

Real Options in Theory and Practice

Graeme Guthrie

Financial Management Association Survey and Synthesis

Preface
1. Introduction
I Foundations
2. The modeling framework
3. Valuing single-period cash flows
4. Valuing multi-period cash flows
5. Combining valuation and decision making
II Component Real Options
6. Options that do not affect the state of a project
7. Simple timing options
8. Compound timing options
9. Über-compound timing options 200
10. Switching options
11. Learning options
III Calibrating the Model 293
12. Calibration using spot and futures price data 294
13. Calibration using option price data
14. Calibrating trees of alternative state variables
IV Putting the Pieces Together
15. Forestry management and valuation
16. Developing a gas field
17. Mothballing an ethanol plant
18. Where to from here?

Real Options in Theory and Practice

Graeme Guthrie

Financial Management Association Survey and Synthesis

Author Information

Graeme Guthrie is a professor in the School of Economics and Finance at Victoria University of Wellington, New Zealand. His research has appeared in the top journals on finance and economics, and as a consultant he has provided advice on a wide variety of issues in relation to agriculture, electricity, gas, real estate, and telecommunications, much of it using real options analysis.